Morgan Stanley’s Farcical Facebook Settlement

By Jonathan Weil -
Dec 20, 2012

Massachusetts Secretary of the
Commonwealth William Galvin this week accused Morgan Stanley (MS) of
breaking the law as lead underwriter in Facebook Inc. (FB)’s initial
public offering, triggering a $5 million fine.

What had Morgan Stanley done wrong? The allegations, as
written by Galvin’s office, seem to have been crafted with one
goal in mind: To make it impossible to answer that question.

Let’s start with the consent order Galvin issued as part of
his office’s settlement with Morgan Stanley. The first 92
paragraphs include a description of the securities regulator’s
jurisdiction and authority, a list of the relevant parties, and
a 16-page statement of facts.

Next is a section called “violations of securities laws,”
which lists three counts. Each count says the regulator
“restates and incorporates the facts set forth in paragraphs 1-
92.” After that, they say “the conduct of respondent, as
described above, constitutes a violation,” followed by
citations of the state laws, regulations or other provisions
Morgan Stanley supposedly breached. The alleged infractions
include dishonest or unethical conduct, disobeying a 2003
consent decree on analyst research, and failing to supervise
employees.

Nothing Obvious

Which facts constituted which violations? There’s no way to
determine that from the order. When I asked Galvin during a
phone call, he declined to answer the question. As far as I can
tell, even viewed in the worst possible light, none of the
conduct described by Galvin was an obvious breach of anything.

Morgan Stanley paid anyway, without admitting or denying
Galvin’s allegations. That’s understandable. The fine amounted
to 7 percent of its $67 million of fees from the IPO -- a
classic nuisance settlement. The real crime here seems to be
that Facebook’s stock price fell a lot after the company went
public in May, which of course isn’t a crime at all.

Here’s the gist of what happened. At an April meeting,
according to Galvin’s version of events, Facebook’s chief
financial officer, David Ebersman, told research analysts at the
company’s underwriters that Facebook’s revenue forecast for the
second quarter of 2012 was $1.1 billion to $1.2 billion. For the
year, he told them Facebook’s forecast was $5 billion.

These numbers weren’t in Facebook’s February registration
statement. Nor, it should be noted, was Facebook required by
Securities and Exchange Commission rules to disclose numerical
forecasts in its public filings.

The SEC historically has discouraged pre-IPO companies from
providing such projections in writing, out of concern that they
are unreliable and that companies would be tempted to inflate
the numbers to hype their offerings.

In May, after Facebook had begun a roadshow for
institutional investors, Morgan Stanley’s top investment banker
on the deal, Michael Grimes, learned the company had reduced its
revenue estimates. How did he respond? He told the CFO that
updating the company’s guidance to the research analysts would
be a good idea. Facebook executives agreed.

Grimes helped Facebook’s treasurer at the time, Cipora Herman, rehearse what she would say in phone calls to the
analysts. Grimes wrote a script for her.

He also drafted language for an amended registration
statement that Facebook filed with the SEC on May 9. The filing
contained new information about threats to the social-media
company’s revenue growth -- a disclosure widely reported in the
press at the time.

Facebook’s treasurer called the underwriters’ research
analysts, about 20 in all, and provided the revised revenue
estimates. Once again, Facebook didn’t include numerical revenue
forecasts in its amended SEC filings. The SEC’s rules on
selective disclosure, known as Regulation FD, didn’t apply to
Facebook before its IPO was completed. Those rules apply only to
companies that already are public.

No Facts

Galvin’s consent order quoted a portion of the 2003 analyst
research settlement that said Morgan Stanley investment bankers
can’t “seek to influence the contents of a research report or
the activities of research personnel for purposes of obtaining
or retaining investment banking business.” The order suggested
Morgan Stanley had flouted this provision. It’s hard to see how.

Galvin’s order contained no facts suggesting that Grimes’s
purpose was to get investment-banking business. Grimes simply
wanted Facebook to come clean with the analysts, who previously
had been given erroneous numbers.

A news release by Galvin’s office this week said, “While
retail investors were left to interpret vague qualitative
information” in the registration statement, “syndicate
research analysts were given specific numbers in order to revise
their revenue estimates.”

This may be true. However, Galvin’s consent order didn’t
say it was a violation. Under the SEC’s rules, disclosures of
this sort are legal -- and to be expected -- in the IPO process.
Plus, whatever disclosure obligations there may have been, they
belonged to Facebook, not Morgan Stanley.

Institutional investors that buy IPO shares from a
company’s underwriters normally have access to more information
than retail investors who buy in the open market after an IPO is
completed. Maybe this isn’t fair. But if Galvin wants to do
something about it, he should lobby the SEC or Congress to
change the system.

During the phone call with Galvin, I also got the
impression he lacked some basic facts. At one point, for
example, he said, “They’ve acknowledged a violation of the
rules,” referring to Morgan Stanley. Actually, his consent
order said Morgan Stanley didn’t admit or deny any violations.